How to Invest in Bonds

Manny Schiffres explains and dissects the complicated world of bonds.

How to Invest in Bonds I’m Manny Schiffres of Kiplinger’s to talk about bonds, one of the best investments for producing income. A bond is basically an IOU from a government or a company that borrows money to fund its operations or for other purposes. In exchange for you lending the money, a bond is a promise that you’ll get your money back at a certain date in the future. When the bond matures, you’ll get a certain amount of interest, generally a fixed rate along the way. Several factors go into determining a bond’s interest rate. For starters, interest rates generally key off the interest of US treasury bonds which are considered the safest type of bond in terms of the likelihood that the issuer, in this case Uncle Sam, will make good on the promise to pay interest and repay principal in a timely manner. The higher a bond is with quality, the lower the interest rate the issuer will have to pay. So for example, a super strong company like Exxon Mobil or Johnson & Johnson will pay less interest than a smaller company you’ve never heard of. Another factor that determines a bond and interest rate or its yield is the time it takes to mature. In general, the longer bond’s maturity, the greater the yield because the issuer must compensate investors for the higher risk of inflation routing the value of the bond over the long-term. In addition, the initial bonds issued by state and local governments pay less interest than comparable corporate and treasury bonds. That’s because the interest from so-called munis is generally exempt from federal income tax and maybe exempt from state and local taxes as well. Inflation is one of the biggest risks by holder space, the likelihood that their money will be worth less when they get it back than when they loaned it out. Another is interest rate risk. If market interest rates rise after you buy a bond, the value of the bond will fall since it’s paying a lower rate than newly issued bonds. And then, there’s credit risk, the risk of the issuer might default. You can invest in bonds by buying them directly through a broker or through mutual funds and exchange traded funds. Funds give you diversification and professional management but their prices will fluctuate. If you a buy an individual mutual bond and hold it to maturity and the issuer doesn’t default, we get back the original investment, although how much that’s really worth will depend on the level of inflation during the time you have the bond.